Market down but not out for the count

Click here to view an edited video of the discussion

THE PANEL:

Anthony BelchambersChief executive,Futures and Options Association

Patrick BirleyChief executive, European Climate Exchange

Gavin LavelleChief executive,Brady

Piet-Hein Ingen HouszGlobal head of metals and steel commodities, Fortis Bank

Sean CorriganChief investment strategist,Diapason Commodities Management

Charles MorrisonPartner and head of trade finance,DLA Piper

Andrew OwensChief executive, Greenergy

THE ISSUES:

• Is the commodities business driven cyclically or structurally?

• When governments condemn commodity investors as ‘speculators’, where does that leave institutional investors?

• Has technology fully transformed these once most traditional markets?

• What effect is the credit crunch having on the industry?

• What next?

THE KEY ISSUE: Is the commodities business driven cyclically or structurally?

In the course of the past decade, commodities financing and investment has moved from being a mere sideshow to centre stage. Edward Russell-Walling, contributing editor of The Banker and chair, asked the group whether these dramatic changes were the result of cyclical or structural forces. Sean Corrigan, chief investment strategist at Diapason Commodities Management, replied that the answer, clearly, was both.

“We have structural change with the industrialisation of the Far East, the rebuilding of the former Soviet Union and the spread of material prosperity to other parts of the world,” said Mr Corrigan. “But we have a cyclical element – the Western business cycle – which is in a very parlous state. The unanswered question is, how much of what we think is structural – in the light of China, and Brazil, and everywhere else – is actually just a reflection of our cycle? That’s what we’re finding out at the moment.”

Piet-Hein Ingen Housz, Fortis Bank’s global head of metals and steel commodities, pointed out that commodity prices were unlikely to behave entirely cyclically for at least one good reason. “The cost of developing mines and oilfields has risen significantly,” he said. “So while commodity prices have dropped in recent months, they are unlikely to go back to the old levels of the beginning of this century.”

Anthony Belchambers, chief executive of the Futures and Options Association, noted another progressive structural influence on the industry. “In agriculture, we have seen the unravelling of price subsidies and government-driven cartels, which is freeing up price,” he observed, adding that more of the same should be expected.

The introduction of biofuels, whereby agricultural crops are used to generate energy, was yet another example of a step-change in the world of commodities, said Patrick Birley, chief executive of the European Climate Exchange. “Using agricultural production for energy has caused a shift in the way that agricultural land is being used,” he said, “and that has created some changes in the pricing of agricultural products.”

He didn’t, however, envisage any mainstream convergence between agricultural and energy commodities. “We talk about commodities markets as a singular thing, but it’s like talking of Asia as a single region. The link between agriculture prices and energy prices is still very tenuous.” He accepted biofuels had been partly responsible for the rise in agricultural prices, but thought it was a short-term phenomenon.

Mr Corrigan begged to differ, saying investors were definitely focusing on agriculture as an energy substitute, with its resulting influence on planting decisions. He reckoned there was now greater correlation between the prices of diesel and oil seeds, or between gasoline and sugar and corn, and people were trading those correlations.

Energy has been a growing input cost for agriculture but, beyond that, Andrew Owens, chief executive of independent fuel company Greenergy, didn’t see a day-to-day relationship between the two. “The reason it looks like they are linked is that everything has moved out of range,” he said.

“Everything’s gone up. So if everything’s gone out of range by 50% to 100%, it looks as if there’s a correlation. But once things settle at the level that they’re going to be, you won’t see day-to-day cause and effect between energy prices and food prices,” he added.

Gavin Lavelle, chief executive of commodity trading software specialist Brady, said there was one overwhelming reason why commodity growth trends would defy cyclicality. “In 1950, the world population was two billion. By 2050 it is forecast to be 10 billion. That will mean an extraordinary change in demand for resources.”

Mr Owens was keen to differentiate between elastic and inelastic commodities. “We have more land than people can imagine and most of what is used is badly managed,” he said. “Just applying an ordinary managerial regime to it would lead to a highly productive increase in output. With an inelastic commodity like oil, you can make all the forecasts you like, but there is still only a certain amount of oil. The two have to be treated differently. For one, supply and demand can come into absolute balance by means of price. With the other, price has to take place just to mitigate demand, because you have inelasticity of supply.”

• WHEN GOVERNMENTS CONDEMN COMMODITY INVESTORS AS 'SPECULATORS', WHERE DOES THAT LEAVE INSTITUTIONAL INVESTMENT?

Mr Belchambers noted that populist politicians love to use the pejorative term “speculators”, because of the knee-jerk reactions it causes. “But the fact is that financial trading is critically important to commodity markets,” he insisted. “Financial traders add depth, liquidity and, because they are reflecting an authentic trading sentiment, substance to the price.”

There is a distinction between the investment banking model (under the microscope at the moment) and the financial trading function, he pointed out. “Financial trading in a market isn’t just the preserve of banks. There are plenty of physical players with big, experienced corporate treasuries, who do trade on price. We need to categorise this more carefully,” he said.

Mr Belchambers conceded that there were critical issues concerning when speculation became excessive, or when it drifted over into market abuse. “But this kind of blind attack on speculators and the way it has been couched has been singularly unhelpful. And it’s a million miles from the truth, because most physical traders will say these are the guys who take the opposite end of the hedge.”

Charles Morrison, partner at international law firm DLA Piper, felt that government criticism of the market was sometimes justified, particularly when banks shifted their emphasis away from orthodox banking and trade financing to more complex – and more profitable – products. “When a bank takes its eye off financing the physical and concentrates more on the credit derivative side of the deal, the question can properly be asked: is that a necessary market?” he said. “Is it really performing a function, or is this investment banks at the top end playing to make money for themselves?”

Mr Lavelle acknowledged that the extraordinary growth in some of the more esoteric derivatives markets was largely because banks had not been making satisfactory returns elsewhere. “Innovation within the banking community is one of the core strengths of the City and world finance,” he said. “But it comes back to a question of balance, and what we’re seeing now is a correction of over-enthusiasm in those areas.”

As someone working to establish a new commodity market – for carbon emissions – Mr Birley spends most of his time out on the road looking for speculators and liquidity providers. “I am trying to encourage people to get involved who are not necessarily fundamental players in that commodity space, to provide liquidity: arbitrageurs, long-term investors and speculators. Remember, we are a risk transference market.”

Mr Owens said it was important to nail the myth that derivatives are separate from the real market. The physical market and derivatives are synonymous, he insisted. “In commodities, the supply chain is close to a zero sum game,” he said. “You’re looking at 1% margins. Now, you can’t put your capital into play if you can’t lock those 1% margins in. It’s simply not possible for the supply chain to exist without derivatives because the capital risk ratio is untenable for any finance director or investor.”

Mr Corrigan had a salvo for governments everywhere. “Governments have always wanted to hang the speculators, and our friends in government today would like to do the same thing,” he said. “But who caused the agricultural spike? It was governments: hoarding materials, banning exports, paying subsidies for people at home to eat more than they could afford in the free market. The oil business is one big resource grab. There’s plenty of oil in the ground if you let the best companies go and find it but they’re not allowed to. So why blame us for trading it, finding it is scarcer than it used to be and moving the price up, when the artificial scarcity comes from our friends in politics?”

• HAS TECHNOLOGY FULLY TRANSFORMED THESE ONCE MOST TRADITIONAL MARKETS?

Mr Lavelle predicted that many organisations that had not yet traded in commodities would enter the marketplace. This meant that prices for intermediaries would come down. “And that means that organisations need to become more efficient,” he argues. “There is absolute opportunity for this. It’s all about lower cost of ownership, more efficient transactions and, ultimately, about audits, compliance and control of business.”

He said it was extraordinary that the London Metals Exchange (LME) still had people sitting in a ring and shouting at one another. “There’s a clerk in a booth who sends a fax back to his bank to transact business,” Mr Lavelle said. “I don’t think that’s the most efficient way.”

Others defended the LME and its choice of three trading systems (including electronic and telephone trading), but Mr Lavelle insisted that the trend was clear. The market was going electronic, however long it took, resulting in more efficient pricing and brokerage rates for the clients.

Mr Ingen Housz disputed the idea that the number of physical traders was likely to grow. He said he had been in commodity trade finance for 10 years, and Fortis still had the same number of clients as it did when he started, though it now did three times as much business with them. The costs of entry made it difficult for new players to enter the market. “But who will be the winners that survive?” he asked. “They will be the ones who have their act together on the operational side. They have to have the systems in place and they must invest a significant amount in those systems.”

Mr Owens predicted a big swing away from over-the-counter market paper contracts, as a direct result of the credit crunch, which has made counterparty risk a front-row issue. “You could see lots of trade come onto the exchanges, where you don’t have counterparty risk,” he suggested. Mr Birley said that centralised clearing assumed a certain level of liquidity in a market, and that the exchange model only worked with commodities that had a critical mass.

• WHAT EFFECT IS THE CREDIT CRUNCH HAVING ON THE INDUSTRY?

Mr Belchambers argued that the credit crunch was essentially about complex structured products, a particular feature of financial markets. Commodities, he felt, were sitting in a slightly different risk space.

Mr Corrigan responded that the effects had been significant and would remain so, but for a different reason. He agreed on the complexity issue, but pointed out that the credit cycle is the business cycle: “And it’s the business cycle that’s bust. That’s why we now have a potentially weaker overlay for commodities. We’re going to have all these things in phase, as we did two years ago.”

Another contributing feature was the destruction of leveraged finance, with some of the most active commodity funds shutting their doors. Then there had been scares over exchange-traded commodity funds, where investors thought they owned the physical commodity but actually had only a derivatives contract with troubled AIG.

“There has been a focus on the simple, on exchange trading, on the physically held and on good counterparties,” said Mr Corrigan. “At the core of the industry, most of us have come out of it well. But the cyclical downswing reduces the ability of producers to go out and finance exploration and replacement. So somewhere down the road, we’ll find that supply again becomes an issue.”

Basel II has affected commodity financing, as it has other forms of lending, and has encouraged banks to use more sophisticated structures to keep risk-weighting at an acceptable level. Much work is being done on the development of warehouse receipts and other mechanisms to help the money flow at the point of origin. “Those of us dealing with the physical financing have these restrictions overlaid to the credit crunch, which is giving rise to a lack of liquidity and an inability of banks to finance traders,” said Mr Morrison.

Mr Ingen Housz observed that before the crunch the structures of commodity deals, particularly in the form of pre-export finance, were getting “looser”. “They were becoming more and more clean, more like corporate lending,” he said. “Now we are back to traditional pre-export finance transactions with tight structures.” Secured lending not only absorbed less of the bank’s capital but also cost the trader less – and he wanted to see more large traders swap their clean credit lines into secured credit lines.

There had been a move away from “some of the sillier” project developments to more genuine projects that made industrial sense, said Mr Owens. “Projects are being cancelled left, right and centre because companies can’t get loans,” he explained. So any that raised speculative capital were giving way to those funded by companies – such as­ ­Greenergy – with cashflow and profits.

Mr Lavelle provoked murmurs and nods of agreement when he said there would be a political backlash. “There has been a tremendous investment in Basel II and the development of risk management techniques,” he said. “The banks are still having hard times and the question is: what next? The knee-jerk reaction to WorldCom and Enron was Sarbanes-Oxley, which became very onerous for organisations.

“We know there will be a backlash and the challenge for our trading business is to ensure that it continues to thrive. There are plenty of people sitting in Dubai or Bangalore or Hong Kong who would love to see the trade flows that come through London and New York. We should be very careful to maintain that status quo.”

What about the impact on investor appetite for this asset class? Many who have profited from it in recent years have used some of their gains to offset losses elsewhere – pulling up the flowers to water the weeds, as they say in the markets. “There are people who worry that we’re on the verge of another Great Depression and that commodity prices will be crushed, so some of that money has withdrawn,” said Mr Corrigan. “Conversely, others are still building up their allocations. The initial customers were private bank types and people with structured products for retail. But the message has increasingly been getting through to pension funds and insurance companies that they should have some of this in their portfolios.” He added that, for those who believe in the Great Depression, the day after President Roosevelt reopened the banks and devalued the dollar, commodity prices rose immediately and continued to do so “for the next four or five years”.

• WHAT NEXT?

No one believed that the commodities business will fade away. Demand may be falling off along with world economic growth, but it will turn. Mr Belchambers said that it was not just the quantity of demand but also its sophistication that would grow. “As emerging countries become more sophisticated, their demand for different commodities in different forms will also grow,” he forecast.

Mr Ingen Housz agreed: “What we see as a bank is that most of the investment in producers and processors of commodities is in the emerging markets, where the low-cost producers are, and particularly in Brazil, Russia, India and China. And therefore it makes economic sense to invest in these markets, because it will only continue.”

Mr Lavelle offered the viewpoint of a client, an aluminium can recycler: “The way they think about the world is via the consumption of aluminium cans. In China, it’s one can per person per year. In Europe it’s one per person per week. In the US it’s one per person per day. So if you think there will be a balancing of that, it means tremendous growth in the usage of raw materials.”

That’s not to say it’s back to business as usual. Mr Belchambers predicts that there will be a pulling away from the commodities community by the banks – for now. “Everyone is in post-crisis hair-shirt mode, where we go back to a more traditional banking model and we don’t do that sort of thing,” he said. “But then the banks will be pressurised to deliver the performance expectations of their stakeholders, and there will be the inevitable stretch in risk appetite. And then I think they will come back in – differently.”

The business actually couldn’t do without investment bankers, said Mr Ingen Housz. “Physical traders don’t basically take outright positions in commodities,” he noted. “They are logistical service providers and they make their money by doing arbitrage in the premiums. In order to be able to hedge, they need the investment bankers.”

If banks’ commodity dealings were curtailed, voluntarily or otherwise, this need not necessarily have a major impact on the industry itself. “Most commodities are under the control of commodity businesses, not under the control of banks,” said Mr Owens. “Banks might be lending to the commodity businesses but most oil is not moved by a US ex-investment bank. We actually find it easier now to fund our commodities, as such. The ability to fund some stock in a tank is easier than it was 12 months ago. Getting a loan to build the tank is nigh on impossible.”

Access to commodities either as business or as an investment depended on trade, Mr Owen maintained. So what was really important was how the credit crunch affected the way politicians looked at free trade. “Because it is free trade and the globalisation of trade that enables any financial institution to have any access to commodities at all,” he said. Mr Morrison agreed.

“We’re really going to see the fallout from the failure of the Doha round [of WTO talks on trade liberalisation],” he said. “That was an opportunity to address these points, and they are not going to be addressed, so what are the consequences? Will the credit crunch force the negotiators back to the table?”